Get Stock-Like Gains Without the Stock-Like Risks

Convertible bonds are a great way for investors to get stock-like returns with lower volatility than stocks. But because the bonds can be tricky to manage, they’re best bought through a mutual fund. And few funds have handled these intricate hybrids with more aplomb than Vanguard Convertible Securities (symbol VCVSX).

“Converts” pay a fixed rate of interest, like regular bonds do, but they also have a potential kicker: They can be converted into shares of the underlying firm’s stock at a preset price.

Over the past year to December 17, Vanguard Convertible rose 20%, beating the average of other convertible-bond funds by nearly three percentage points on an annualized basis. And the fund, which started in 1986, has delivered stellar long-term results. Over the past ten years, it gained 7.0% annualized, beating Standard & Poor’s 500-stock index by an average of nearly six percentage points per year.

What’s more, since the fund began it has never underperformed similar funds or its benchmark -- the Bank of America Merrill Lynch All Convertibles All Qualities index -- in any ten-year period.

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What’s the potential downside of such bonds? Most convertibles have “junk” ratings, which means the risk that the issuer could default is greater than it is with investment-grade bonds. Convertibles tend to be less risky than stocks and fall less in bear markets, but they also rise less in bull markets. During the last bear market, from October 2007 through March 2009, convertible bonds, on average, lost 39.2%, while stocks in the S&P 500 lost 55.3%. Vanguard Convertible Securities lost 34.3% during that time.

Convertible bonds have been growing in popularity as wary investors look for ways to get stock-like returns without taking big risks. That is precisely the goal of Vanguard Convertible’s manager, Larry Keele. Keele, who has run the fund since 1996, seeks bonds that have more upside potential than downside risk.

In particular, he looks for convertible bonds maturing in three to ten years that trade close to their face value, or par. Explains Keele: “If we buy a five-year convertible with a 4% interest coupon at par, the worst-case scenario, as long as the firm remains creditworthy, is a 4% annual return.”

And because the bond can be converted into shares of the underlying stock, the bond’s price can rise along with any increases in the stock’s price. That’s how Keele achieves stock-like returns using bonds.

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Keele keeps a diversified portfolio of convertibles, with issuers ranging from MGM Resorts International to Virgin Media to Gilead Sciences. He also looks for convertible bonds with call protection, which means the company cannot call the bond back.

Because most convertible issuers have junk-bond ratings, Keele devotes a lot of effort to making sure the companies whose bonds he buys are financially healthy enough not to default. That has become easier for Keele recently -- since the recession, many companies have strengthened their balance sheets by building cash and paying off debt.

Keele also keeps close tabs on bonds’ price appreciation. When a bond’s price rises enough, he sells it and reinvests the profits in other bonds. That enables Keele to reduce the risk of the portfolio, because as a convertible bond rises in price its volatility becomes more like that of the underlying stock.